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Chinese peg, policy and effects

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China pegs the yuan to the US dollar at 8.3 yuan per dollar. Suppose that this is above the equilibrium level of the dollar in the foreign exchange market. What must the People's Bank of China do to maintain the peg? Next suppose the Chinese government abandons the peg and allows the yuan to float. With the help of a graph of the foreign exchange market from the Chinese perspective-where China is the home country so e has the dimensions of yuan/$-explain what will happen. What would be the effect on Chinese imports and exports?

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First a fixed or pegged rate is the rate, which the government sets and maintains as the official rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

A country might decide to use the pegging method in attempts to create a stable atmosphere for foreign investment. With a peg the investor will always know what his/her investment value is, and therefore does not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency. With a fixed currency, there is less speculative activity. Further, it should be noted that countries with pegs are usually associated with having unsophisticated capital markets and weak regulating ...

Solution Summary

What would be the effect on Chinese imports and exports?

See Also This Related BrainMass Solution

Issues involved with pegging or floating the yuan to US dollar

Prior to the financial crisis in 2007/2008, the U.S. Treasury Department as well as Congress had been asking China to revalue upwards the value of their Renminbi or Yuan. China responded to these repeated requests by allowing the Yuan to trade within a narrow band. The band itself was then shifted upwards or downwards by small increments from time to time. Still, the U.S. claimed that China had not done enough and should raise the value of the Yuan by at least a further 20%. The reasons given to justify this requested increase were as follows:
1. The artificially low value of the Yuan makes U.S. manufactured exports unattractively priced in China.
2. The undervalued Yuan leads to excessive U.S. imports of Chinese-made goods, which in turn, leads to an unwelcome trade balance in China's favor. For example, the trade deficit with China was roughly -$258,506.0 million in year 2007. These numbers shrunk further during 2009 as recession hit the global economy. In year 2011, the trade deficit with China was roughly -295,456.5 million (http://www.census.gov/foreign-trade/balance/c5700.html).

China chose to change their 'floating' arrangement and pegged the Yuan to the USD at a rate they selected. China holds such a large investment in U.S. Treasuries as a result of the continuing U.S. trade surpluses that the U.S. does not have a great deal of leverage. If China sold those Treasuries the U.S. dollar would fall significantly in value.

Discuss what the issues are involved with pegging or floating the Yuan to the US dollar. Use References.

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